Market Levels Market Returns Economic Releases Overview US Treasury Bonds Large-Cap Equities Corporate Bonds

Mortgage-Backed Securities Municipal Bonds High-Yield Bonds European Equities Western European Equities

Global Bonds Emerging Market Bonds Factors Shaping Markets Next Week

	FRIDAY* LAST WEEK DEC.31 2007 1 YR AGO Dow Jones Ind. Avg. 8,521 7,997 13,265 12,958 S&P 500 863 807 1,468 1,428 Nasdaq 100 1,499 1,386 2,652 2,581 The Russell 2000 457 412 766 743 DJ STOXX Europe 199 194 365 354 Nikkei Index 8,213 8,273 15,308 15,223 Fed Funds Target 1.00% 1.00% 4.25% 4.50% 2-Year U.S. Treasury    Yield 1.10% 1.06% 3.05% 3.07% 10-Year U.S. Treasury    Yield 2.98% 3.32% 4.03% 3.95% U.S.$/Euro 1.28 1.25 1.46 1.48 U.S.$/British Pound 1.52 1.5 1.98 2.07 Yen/U.S.$ 95.41 95.73 111.71 108.97 Gold (London) $811.45 $734.55 $833.92 $812.59 Oil $51.71 $53.62 $95.98 $94.42

  *Levels as of 10:45 a.m. PST

	Year to Date (1/1/08 - 11/26/08)   Dow Jones Industrial Avg -35.77% S&P 500 -41.20% NASDAQ -43.50% Russell 2000 -40.37% MSCI World Index -45.67% DJ STOXX Europe 600 (euro) -45.47% Year to Date (1/1/08 -11/25/08)   90 Day T-Bill 2.23% 2-Year Treasury 6.56% 10-Year Treasury 11.85% ML High Yield Index -32.13% JP Morgan EMBI Global Diversified -18.93% JP Morgan Global Hedged 6.42%

ECONOMIC RELEASES
November 24 Existing Home Sales -- Existing home sales slumped by about 3% in October to 4.98 million units at an annual rate. Single-family home purchases fell 3.3% and condos dipped 2%. Sales were down across all four geographic regions. The inventory of unsold homes remains high: 10.2 months’ supply at the current sales rate.

November 25 Third Quarter Gross Domestic Product (second version) – The contraction in real gross domestic product (GDP) was revised down to -0.5% from -0.3% at an annual rate. Consumer spending was revised down to an annualized decline of -3.7%. Exports provided the big boost to growth during the third quarter, adding 1.1 percentage points.

Consumer Confidence -- The Conference Board’s consumer confidence measure rebounded to 44.9 in November from 38.8 October, likely reflecting the decline in gas prices. Overall, the confidence measure remains extraordinarily low. In fact, it’s at the second-lowest reading on record for the series.

November 26 New Home Sales – Sales of new homes fell 5.3% in October to 433,000 at an annual rate. This is the lowest level on this measure since January 1991. The months’ supply of new homes rose to 11.1 in October from 10.9 last month on the dip in sales.

Durable Goods -- Durable goods orders dropped 6.3% in October on a huge, 25% decline in the defense orders. If we exclude defense and aircraft orders, core durable goods orders were down 4.6% during the month, after dropping 3.1% in September and 4.0% in August. Nondefense capital goods orders excluding aircraft, which are a good leading indicator of business investment activity, fell 4.0% in October after dropping during the previous two months as well. It looks like business investment will continue to decline into next year.

Personal Income -- Personal income rose 0.3% in October. Wage and salary growth rose only 0.1%. Versus year ago levels, wage and salary growth was up 2.4%--the slowest pace in four years. With the slow pace of wage gains, it is not shocking to see consumer spending drop— but October’s 1% decline was more than most expected. Meanwhile, less spending means more saving. The savings rate rose to 2.4% in October from 1.0% in September. We expect to see the savings rate ratchet up further into next year. The good news is that, in terms of inflation, the Fed’s favorite measure of inflation, the core (which excludes food and energy prices) personal consumption expenditure deflator, dipped to 2.1% year-over-year in October.

COMMENTARY
Overview

• This week the US government added TALF to the alphabet soup of lending programs and market chatter increased about a concept called quantitative easing. First, what is TALF? TALF is the Term Asset-Back Securities Loan Facility. Under this program, the Federal Reserve Bank of New York will lend $200 billion in non-recourse loans to holders of AAA-rated asset-backed securities (ABS). The goal of the program is to support the asset-backed securities market, which has seen new issuance plunge since September, leaving less credit available for credit cards, auto loans and student loans. As a result, we are seeing a dramatic decline in consumer spending. Data released on Wednesday showed a 1% plunge in consumer spending during the month of October, the largest one-month drop since January 1990. The contraction in consumer spending appears to be gaining speed.
• What is quantitative easing? Quantitative easing is a central bank policy tool used when the traditional tool, the short-term interest rate target, approaches zero. This is the strategy the Bank of Japan employed beginning in 2001 when its overnight rate hit zero. Instead of worrying about maintaining an interest rate target, the central bank simply floods the banking system with reserves by purchasing assets from banks. In fact, the Federal Reserve has already moved unofficially in this direction in recent weeks. Since October 30, the actual federal funds rate in the market has averaged 34 basis points, or 0.34%. On Tuesday, the Fed announced plans to buy $100 billion in direct obligations of Government-sponsored Enterprises (GSEs) and establish a program to purchase $500 billion in Agency mortgage-backed securities (MBS). As the Fed buys these securities, more bank reserves will be added to the financial system. Will it thaw out the credit markets? Adding more reserves affects the economy in two ways. First, it makes more money available for new bank lending. However, at least so far, banks have been hoarding reserves. Excess reserves on bank balance sheets jumped to nearly $400 billion as of November 7th after averaging $1 billion over the last 10 years. Second, Fed purchases of MBS will help narrow the spread between Treasury yields and longer-term mortgage rates, which have remained stubbornly high. Lower mortgage rates could spark new refinancing and home buying activity, which would boost the US housing market. In the months ahead, we will watch bank lending, money supply and mortgage rates to gauge the Fed’s effectiveness.

US MARKETS
Treasury Bonds

• US Treasuries continued to rally this week on the back of deteriorating economic data. The yield curve continues to flatten, with the spread between two-year yield and 10-year yield moving another 25 basis points lower since the end of last week to 188 basis points. Yields on Agency securities rallied approximately 30 basis points versus US Treasuries and 15 to 25 basis points versus Libor across the curve this week on the Federal Reserve’s announcement that they would be buying $100 billion Agency direct obligations. However, liquidity is still very poor as many investors are still under water from their purchases after the Treasury took Fannie Mae and Freddie Mac into conservatorship in September.
• Swap spreads were able to tighten significantly, as the first of the three-year Federal Deposit Insurance Corporation (FDIC)-guaranteed bank deals was issued successfully into the market on Tuesday. More deals like this will likely follow in the weeks ahead.

Large-Cap Equities

• The equity markets rebounded during this shortened week as the US government provided relief to Citigroup and the Federal Reserve committed $800 billion to the fixed-income markets. The S&P 500 rallied over 6% and the Dow Jones Industrial Average gained about 4.5% for the week. Small-cap stocks outperformed large-cap stocks by about 3% for the week. In terms of style, large-cap value stocks outperformed large-cap growth stocks. The best performing sector was financials and the worst performing sector was utilities. Stocks in the news include financial services giant Citigroup. After the stock price of Citigroup declined over 60% last week, the US government agreed to provide $20 billion in capital and guaranteed $306 billion of its troubled assets. Shares of C rallied 58% on the news.

Corporate Bonds

• Investment grade primary activity (new issuance) slowed to a crawl this week, as most market participants made their way out the door early. There were only a handful of deals that came to market this week. One noteworthy deal was the first time issuance of FDIC-backed debt in the United States issued by Goldman Sachs. They came with a $5 billion three and a half-year deal priced at +200/curve. JPMorgan and Morgan Stanley also came with FDIC-backed debt. We expected this type of issuance to continue as it opens a new avenue for bank funding.
• Investment grade corporate spreads widened most of the week as cash bonds lagged the move made by equities and indices. With trading volumes down and most of the street out for most of the week, spreads followed the path of least resistance, which was wider. Trading should pick up slightly the first two weeks of December but we expect trading to taper off the latter half of the month. The Lehman Credit Index Option-Adjusted Spread (OAS) finished the week at +532, nine basis points wider. Telecom/cable/media widened by 40; utilities widened by 20; industrials widened by 34; and financials widened by 36 basis points.

• The quantitative easing campaign has commenced! Agency mortgage prices soared on news that the Federal Reserve will purchase $500 billion in agency mortgages (Fannie Mae, Freddie Mac, and Ginnie Mae). This represents an aggressive move to combat deflation risk by driving down the conforming mortgage rate. The 30-year current coupon mortgage spread versus the 10-year Treasury compressed 30 basis points to 179 basis points as investors raced to front-run US Government buying program. At current spread levels, agency mortgages remain a compelling investment option with Treasury yields at record lows.

• The municipal market gave up some ground this week. With dealer year-end concerns, many desks thinly-staffed due to the Holiday and fatigue from new issue pricing, market tone deteriorated resulting in poor liquidity and reduce trading volumes. Two-year yields rose approximately 10 basis points to 2.15% while 10-year yields rose 20 basis points to 4.00%.

• The introduction of the new Treasury $200 billion TALF (Term Asset-backed Securities Loan Facility) program and the “lifeline” provided to Citigroup by the Federal banking authorities have given a boost to the capital markets, and this has shown up in the equity markets. The rally in the equity markets and anticipation of the new lubrication provided to the credit markets by the TALF and numerous others programs, are having a positive impact on the high yield market. During this holiday-shortened week, the Merrill Lynch high yield index is up +0.5%, a nice reversal from what has been an otherwise challenging November. Much of the attention next week will be on the Big Three Automakers (all high yield rated issuers) as they appear again in front of the US Congress to present their case for a bailout.    

• Stocks in Western Europe gained ground over the past week. The stocks with the best performance were steel producer ArcelorMittal (+34.3%), life and health insurance provider Aegon (+30.1%), and Deutsche Bank (+28.9%). ArcelorMittal rose after BHP Billiton abandoned a yearlong hostile bid for Rio Tinto Group that threatened to concentrate control over iron-ore resources. Among the stocks that did not fare well Volkswagen (-19.4%) led the way, followed by gas company GDF Suez (-2.1%) and electricity company Enel (-0.8%). Volkswagen fell the most in almost a month in Frankfurt trading as a reduction of the carmaker’s weight in the MSCI global indexes forced tracker funds to sell the stock.

Eastern European Equities

• The CECE index of equities traded in Central Europe (Czech Republic, Hungary, and Poland) gained +16.3% this week, while the Russian stock index RTS finished the week up by +13.5%. In Central Europe, Polish construction company Polimex Mostostal (+22.5%) gained the most, followed by Czech broadcaster CETV (+21.6%) and Polish BRE bank (+19.9%). Polimex Mostostal’s stock went up after the company reported excellent Q3 earnings. BRE bank jumped as banks across Europe advanced after Citigroup Inc. received a $306 billion loan guarantee. Among the stocks that did not fare well, Polish oil refinery Grupa Lotos (-7.8%) lead the way, followed by Czech drug manufacturer Zentiva (-2.6%) and Polish biotech company Bioton (0.0%). Grupa Lotos tumbled saying that profit from turning crude into oil products has declined compared to previous months. The refinery expects Q4 earnings to be hurt by a drop in inventory values and currency hedging. In addition, the Deputy Treasury Minister said that a slowdown in Poland’s economic growth may lead the government to merge PKN Orlean and Grupa Lotos, the country’s largest oil refiners. Zentiva lost despite an approval of Sanofi-Aventis’ bid extension to buy out Zentiva’s shares by the Czech Central bank.
• In Russia, the leaders of the week included power company RusHydro (+61.2%), oil producer Rosneft (+29.2%), and gas company Gazprom (+22.6%). RusHydro surged after the Federal Tariffs Service allowed the state-controlled hydropower producer to raise prices 31% next year. Rosneft, Russia’s biggest oil producer, gained after crude oil advanced. In addition, Rosneft – together with Transneft – is holding talks with China’s National Petroleum Corp. in Beijing about loans for the delivery of Russian oil to China. Gazprom increased after Russian President Medvedev announced plans to open an office in Rio de Janeiro in early 2009. Among the laggers of the week were metals and mining company Mechel (-13.5%), Sberbank (-10.3%), and oil transporter Transneft (-6.6%). Mechel was downgraded to ‘underweight’ by a brokerage as coking and coal production may decline by at least 30% in the fourth quarter. Sberbank, Russia’s biggest bank, fell as deposits declined by 2.5% in October.

Global Bonds and Currencies

• The US government’s rescue plan for Citigroup, a fiscally-expansionary Pre-Budget report in the UK, and the Federal Reserve’s plan to purchase up to USD 600 billion in mortgage-backed assets and USD 200 billion in asset-backed securities dominated the headlines in this holiday-shortened week. Further evidence of a sharp slowdown in global economic activity continued to emerge (for example, the German Ifo November business climate index fell more sharply than expected to 85.8, the lowest level since early 1993, from October’s 90.2). A bounce in longer-term bond yields early in the week following the Citigroup announcement was short-lived, and yields subsequently continued their decline in response to the gloomy economic outlook. By mid-week, UK 10-year Gilt yields were four basis points lower, similar-maturity Bund yields were seven basis points lower, although Japanese bond yields were little changed. However, yield curves reversed their recent steepening trend and flattened slightly, particularly in the UK in response to the Pre-Budget report; 2-year Gilt yields were up by about 20 basis points, while in Germany they rose by approximately 10 basis points.
• In the currency markets, the Citigroup announcement (and the subsequent sharp rally in equity markets) led to an increase in risk appetite and a reversal of the previous “flight-to-quality” trend. This led to weakness in the US dollar generally, and particularly relative to emerging markets currencies. By mid-week, sterling had recovered by 2.8% versus the US dollar, the euro had gained just over 3%, while the yen gained a more modest 0.7% following its earlier sharp “carry-reversal” gains.

• Emerging market dollar-pay debt spreads tightened by 45 basis points this week, following the better tone in risk markets and the cutting of interest rates by certain central banks around the world. The central bank of Hungary this week cut interest rates by 50 basis points to 11%, surprising the market as a “no change” was expected. The combination of lower food and oil prices, as well as weaker domestic demand, prompted the central bank to act. Local bonds were stronger as a result.
• In a surprising move, the Monetary Policy Council (MPC) in Poland decided to cut its reference rate by 25 basis points to 5.75%, due to the deterioration in economic growth prospects and the prospects of a deeper global economic slowdown. In China, the central bank cut the key one-year lending rate by 108 basis points to 5.58%, marking its biggest interest rate cut in 11 years. It comes on the heels of government concerns about rising unemployment, the severity of the economic slowdown and increasing social unrest.

FACTORS SHAPING THE MARKET NEXT WEEK

• Next week’s top US data report will be Friday’s employment report. This week the four-week moving average of initial claims for unemployment insurance hit 518,000—the highest level since the early 1980s, suggesting more weakness in labor market data is ahead.
• Next week’s calendar for Western Europe includes the release of the euro zone’s industrial producer prices on Tuesday. On Thursday, France will report on its employment situation and euro zone GDP data is scheduled to be released as well. Spain will come out with its industrial production numbers on Friday.
• Eastern Europe’s week kicks off with the release of Kazakhstan’s November inflation on Monday. On Tuesday, Romania will publish October’s producer price index data.

NEXT WEEK'S US ECONOMIC RELEASES

December 1 Construction Spending
December 2 Auto Sales
December 3 Productivity, ISM Non-Manufacturing
December 5 Employment Situation